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A comparative analysis of proxies for an optimal leverage ratio

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  • Ranjan D'Mello
  • Joseph Farhat

Abstract

Previous studies that test the tradeoff theory commonly use one of the following debt ratio measures to proxy for a firm's hypothesized optimal ratio: firm's time‐series mean leverage, moving average leverage based on a firm's historical debt ratios, industry median leverage, and predicted leverage ratio based on cross‐sectional regressions. We find that these alternative proxies yield results that are significantly different from each other. Further, regression results of models that use the optimum target leverage and the conclusions drawn from the findings are sensitive to the model's proxy. Of the proxies that are commonly used in the literature, the moving average debt measure exhibits characteristics that are most consistent with the theoretical optimal leverage ratio.

Suggested Citation

  • Ranjan D'Mello & Joseph Farhat, 2008. "A comparative analysis of proxies for an optimal leverage ratio," Review of Financial Economics, John Wiley & Sons, vol. 17(3), pages 213-227, August.
    • Handle: RePEc:wly:revfec:v:17:y:2008:i:3:p:213-227
    DOI: 10.1016/j.rfe.2007.06.001
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